Economics (9640) | Possible conflicts between macroeconomic policy objectives

Macroeconomic Policy Conflicts: Why Governments Can't Have It All

Welcome, future economists! This chapter is one of the most practical and challenging parts of macroeconomics. Don't worry if it seems tricky at first—we’re moving beyond just defining objectives and looking at the difficult reality of running an economy.

Imagine the government is trying to steer a large ship (the economy) toward four different ports at the same time: fast economic growth, steady prices (low inflation), zero unemployment, and a stable international balance of payments. Often, when you try to speed up toward one port, you end up sailing further away from another!

In these notes, we will explore the key trade-offs, or conflicts, that arise when the government attempts to achieve all its main macroeconomic objectives simultaneously. Understanding these conflicts is vital for evaluating economic policy in exams.

1. Quick Review: The Core Macroeconomic Objectives

Governments typically aim for these four core objectives (from syllabus section 3.2.1.1). Conflicts happen because policies designed to achieve one objective often negatively impact another.

• Economic Growth: A sustainable increase in Real GDP (national output).
• Price Stability: Keeping inflation low and stable (often 2%).
• Minimising Unemployment: Aiming for full employment (but not 0%, due to frictional unemployment).
• Stable Balance of Payments (BoP): Specifically, avoiding large, unsustainable current account deficits.

2. Conflicts Involving Economic Growth

When an economy is growing rapidly, it puts a strain on resources and creates several common conflicts:

2.1. Conflict: Economic Growth vs. The Environment

This is a classic long-run conflict, focusing on sustainability.

The Problem:

When an economy grows, production and consumption levels increase dramatically. This expansion often relies heavily on scarce natural resources and generates pollution and waste.

• Resource Depletion: Faster growth means using up finite (non-renewable) resources like oil or minerals more quickly.
• Negative Externalities: More factories mean more air/water pollution (a negative externality of production). More cars mean more CO2 emissions (a negative externality of consumption).

Analogy: If you double the speed of your manufacturing conveyor belt (growth), you double the noise, waste, and energy consumption (environmental damage).

Key Takeaway: Unchecked or "dirty" economic growth often comes at the expense of environmental quality and sustainability, limiting the well-being of future generations.

2.2. Conflict: Economic Growth vs. Equitable Income Distribution

Achieving rapid growth often requires policies that may increase the gap between the rich and the poor.

The Problem:

• Incentives for Investment: Governments often encourage growth by cutting taxes on high earners or company profits to boost saving and investment. However, this immediately increases income inequality.
• Uneven Sectoral Growth: Growth may be concentrated in high-tech or finance industries, benefiting workers with specific skills (the highly educated), while leaving behind those in traditional or low-skilled sectors.
• Capital vs. Labour: Rapid growth driven by investment in machinery (capital) might mean that profits (which accrue to business owners/shareholders) grow faster than wages (which accrue to labour), widening the income distribution gap.

Did you know? This trade-off is sometimes summarised by the phrase "efficiency versus equity." Policies that promote efficiency and growth often harm equity (fairness).

2.3. Conflict: Economic Growth vs. The Budget Balance

The budget balance is the difference between government spending (G) and tax revenue (T). A deficit occurs when G > T.

The Problem:

• Demand-Side Stimulus: To boost short-run economic growth (especially during a recession), the government often uses expansionary fiscal policy: increasing spending on infrastructure or cutting taxes.
• Result: This boosts Aggregate Demand (AD), leading to growth, but it requires the government to borrow money, resulting in a larger budget deficit.

Example: If a country needs to build high-speed rail networks to boost long-run growth (infrastructure investment), this massive cost must be financed, likely leading to a temporary budget deficit.

3. Conflicts Related to Output Gaps (The Inflation-Unemployment Trade-off)

This is arguably the most famous macroeconomic conflict and relates heavily to where the economy sits on its AD/AS diagram.

First, let's quickly define the terms (from syllabus 3.2.3.5):

• Positive Output Gap: Real GDP is above the economy's normal productive potential (LRAS). The economy is "overheating."
• Negative Output Gap: Real GDP is below the economy's normal productive potential (LRAS). There is spare capacity and high unemployment.

3.1. Conflict: Low Unemployment vs. Price Stability (Inflation)

This conflict occurs mainly in the short run when governments try to stimulate AD to reduce unemployment.

Step-by-Step Trade-Off:

1. The government wants to reduce cyclical unemployment (caused by low AD).
2. It uses expansionary policies (like cutting interest rates or increasing government spending) to shift AD right.
3. As AD increases, firms employ more workers, and unemployment falls.
4. However, as the economy approaches or enters a positive output gap, resources become scarce (factories run at full capacity, skilled workers are hard to find).
5. Firms must compete for these scarce resources, pushing up wages and costs. This results in demand-pull inflation.

In AD/AS terms: Pushing AD further right when the economy is near LRAS causes a large rise in the Price Level (P) and only a small increase in Real GDP (Y).

Memory Aid (The Trade-Off): Think of it as a seesaw. When unemployment goes down, inflation often goes up (in the short run).

3.2. Conflict: Balance of Payments Stability vs. Economic Growth/Low Unemployment

If the government boosts AD to stimulate growth or reduce unemployment, this has a negative side effect on the current account balance.

The Problem:

• Rising Income: When incomes rise due to economic growth, consumers feel wealthier and increase their overall spending.
• Increased Imports: A portion of this extra spending will be used to buy imported goods and services (leakage).
• Result: This rapid increase in imports, relative to exports, worsens the trade balance (the largest component of the current account), potentially leading to a deficit.

Example: The UK experiences a sharp boom. People start buying more German cars and Japanese electronics. While the UK is growing, its current account deficit widens.

4. Reconciling Policy Conflicts (The Solutions)

If these conflicts are so common, how do governments manage them? The solution often lies in shifting the focus from short-run demand management (AD) to long-run supply management (LRAS).

4.1. The Role of Supply-Side Policies (SSPs)

SSPs aim to increase the economy's potential capacity (LRAS), shifting the vertical LRAS curve to the right. This allows the economy to achieve growth without causing excessive inflation or BoP problems.

1. Reconciling Growth, Unemployment, and Inflation:

• If LRAS shifts right, the economy can achieve higher output (growth) and lower unemployment (structural employment is reduced via training) at the same price level.
• This avoids the short-run trade-off because the economy has expanded its total capacity, meaning there is less upward pressure on costs and prices.

2. Reconciling Growth and the Balance of Payments:

• SSPs, such as investment in education and infrastructure, often boost the productivity and competitiveness of domestic firms.
• If UK firms become more competitive (e.g., higher quality or lower costs), domestic consumers will buy fewer imports, and foreigners will buy more exports. This helps close the trade gap even as incomes grow.

3. Reconciling Growth and the Environment (Green SSPs):

• SSPs can be specifically targeted towards environmental protection. Policies like investing in green technology, renewable energy infrastructure, or providing subsidies for clean production methods allow growth to occur with less environmental harm. This is called sustainable economic growth.

4.2. Short-Run vs. Long-Run Policy Focus

Many conflicts are strongest in the short run. Policies designed to reconcile conflicts therefore often have a long time horizon:

• Short Run (SR): When using demand-side policies (Monetary or Fiscal) to address immediate problems like cyclical unemployment, conflicts (like inflation or BoP deficits) are highly likely.
• Long Run (LR): Governments use Supply-Side Policies to overcome the fundamental constraints of the economy (low productivity, poor infrastructure). While these policies take time to work, they help achieve all objectives simultaneously without trade-offs.

Key Takeaways and Quick Review

The job of a government is often about managing difficult trade-offs. The solution lies in choosing policies that don't just shift AD, but that improve the entire productive capacity (LRAS) of the economy.

Mnemonic for Growth Conflicts (BIE):

• B: Budget Balance (Growth often causes deficits)
• I: Income distribution (Growth often increases inequality)
• E: Environment (Growth often leads to pollution/depletion)

The Core AD Trade-off (Short Run):

Policies to reduce Unemployment (by increasing AD) tend to increase Inflation and worsen the Current Account Balance.

The Solution (Long Run):

Supply-Side Policies can help reconcile these conflicts by expanding LRAS, allowing for simultaneous non-inflationary growth and improved competitiveness.